How To Set Up A Day Trade Using Fibonacci Retracements

As you may know, I really like Fibonacci Retracements. They are a fantastic tool for technical analysis with many uses and applications. Basically, FR’s are target areas for support and resistance based on ancient mathematical relationships found in nature. At heart is the Golden Ratio, which can be found between all living things such as your arm span compared to your height, the pattern of diamonds on the skin of a pineapple and even the distances of market movement within a trend. In particular, FR’s are especially useful for measuring potential areas of support and resistance when an asset has reversed course, or is retracing its prior path. As an asset travels along that path it will make stops at support or resistance that more often than not correspond to the underlying pattern of the universe. Keep in mind though that Fibonacci’s are not signals, just places where signals could be taken. For more informaiton on how to use FR check out my three rules for trading with Fibonacci Retracements.

If you need to know more about what a Fibonacci Retracement is this is not the article for you. In this piece I will be looking at how to set up a day trade using the FR tool. To start, I always begin with the chart of weekly prices to see what the underlying trend is. I typically only trade in line with the underlying trend, since we will be making our trade on the chart of hourly or 30 minute prices we will be looking for what is happening in the nearest term, based on the weekly chart. In this example I am going to be using one of the gold indexes, the ETF GLD to be precise, as there has been a lot of activity in that sector over the past few days. I always look at this chart when the market is closed, before the start of the day, so that market noise is lessened. In this example we can see that the GLD hit a bottom in late 2020 so I drew my first FR from the top of the move to the bottom. Looking back you can see how the FR levels are coincident with several points of support and resistance. These levels will be important for future trades once the index reclaims these lofty levels. The 23.6% level is what we are interested in now. Analysis here; the long term trend is down, the index is near resistance with weak candle formation and declining momentum. In the nearest term it looks a bull wave within the long term down trend has peaked, time to look for bearish trades.

For the next step I move down to a chart of daily candlesticks. In this example the asset is moving sideways within the longer term down trend, between the 0% and 23.6% FR’s. I next draw another FR on the bounce from the 0% to the 23.6% to check on short term areas of support and resistance. It is uncanny how the FR tool matches up with the market. Notice how price behaves around the FR lines. These levels will also all be important during future moves as price action makes it way higher and lower. Most importantly for us is what is happening now, at the hard right edge. Gold prices in the previous session dropped more than 2% causing a similar drop in the ETF. Now prices are below a FR level, indicating that the next lower level is a primary target. MACD only adds confirmation as it has turned bearish coincident with the move below 38.2%. Trading on this chart would require an expiry of at least several days, if not a week or more to ensure the predicted movement has time to occur. For day traders the next move is to move down to a chart of shorter term prices and wait for the market to open.

Taking The Trade

Until the market opens we can take a look at how the trade might set up. We can see on the 10 minute chart that the 38.2% line is indeed acting as resistance. MACD indicates that some buying may occur and result in a retest of resistance. So, now is the time to wait for prices to form a new signal, I know that as we wait for the market to open there has been a small bounce in gold prices that will have the GLD at or near resistance once trading begins. A mere cross of the line is not a signal, FR’s are not signals, they are places where signals can form. It is imperative to wait for a signal before trading as whipsaws and false break outs can occur. As price action develops the 30 bar EMA acts as resistance in the first half hour until price breaks and tests FR resistance at the retracement line. The first candle to touch or break the line could be a good entry but additional confirmation is usually a good idea. We can see in our chart that prices are held back be resistance,then form a dark cloud cover confirming that resistance. That is when you want to enter with short term expiry, in this case a minimum of ten minutes due to the ten minute candle stick. Additional signals can be taken throughout the day as they present themselves.

How to Use Fibonacci Retracement to Enter a Trade

The first thing you should know about the Fibonacci tool is that it works best when the forex market is trending.

The idea is to go long (or buy) on a retracement at a Fibonacci support level when the market is trending up, and to go short (or sell) on a retracement at a Fibonacci resistance level when the market is trending down.

Fibonacci retracement levels are considered a predictive technical indicator since they attempt to identify where price may be in the future.

The theory is that after price begins a new trend direction, the price will retrace or return part way back to a previous price level before resuming in the direction of its trend.

Finding Fibonacci Retracement Levels

Then, for downtrends, click on the Swing High and drag the cursor to the most recent Swing Low.

For uptrends, do the opposite. Click on the Swing Low and drag the cursor to the most recent Swing High.

Now, let’s take a look at some examples on how to apply Fibonacci retracements levels to the currency markets.

Uptrend

This is a daily chart of AUD/USD.

Here we plotted the Fibonacci retracement levels by clicking on the Swing Low at .6955 on April 20 and dragging the cursor to the Swing High at .8264 on June 3.

Tada! The software magically shows you the retracement levels.

As you can see from the chart, the Fibonacci retracement levels were .7955 (23.6%), .7764 (38.2%), .7609 (50.0%), .7454 (61.8%), and .7263 (76.4%).

Now, the expectation is that if AUD/USD retraces from the recent high, it will find support at one of those Fibonacci retracement levels because traders will be placing buy orders at these levels as price pulls back.

Now, let’s look at what happened after the Swing High occurred.

Price pulled back right through the 23.6% level and continued to shoot down over the next couple of weeks.

Later on, around July 14, the market resumed its upward move and eventually broke through the swing high.

Clearly, buying at the 38.2% Fibonacci level would have been a profitable long-term trade!

Downtrend

Now, let’s see how we would use the Fibonacci retracement tool during a downtrend. Below is a 4-hour chart of EUR/USD.

As you can see, we found our Swing High at 1.4195 on January 25 and our Swing Low at 1.3854 a few days later on February 1.

The expectation for a downtrend is that if price retraces from this low, it could possibly encounter resistance at one of the Fibonacci levels because traders who want to play the downtrend at better prices may be ready with sell orders there.

Let’s take a look at what happened next.

Yowza, isn’t that a thing of beauty?!

The market did try to rally, stalled below the 38.2% level for a bit before testing the 50.0% level.

In these two examples, we see that price found some temporary forex support or resistance at Fibonacci retracement levels.

Because of all the people who use the Fibonacci tool, those levels become self-fulfilling support and resistance levels.

If enough market participants believe that a retracement will occur near a Fibonacci retracement level and are waiting to open a position when the price reaches that level, then all those pending orders could impact the market price.

One thing you should take note of is that price won’t always bounce from these levels. They should be looked at as areas of interest, or as Cyclopip likes to call them, “KILL ZONES!” We’ll teach you more about that later on.

For now, there’s something you should always remember about using the Fibonacci tool and it’s that they are not always simple to use!

If they were that simple, traders would always place their orders at Fibonacci retracement levels and the markets would trend forever.

In the next lesson, we’ll show you what can happen when Fibonacci retracement levels FAIL.

Fibonacci Retracement Levels in Day Trading

Tool to Help Isolate When Pullbacks Could End

Moves in a trending direction are called impulses, and moves against a trend are called pullbacks. Fibonacci retracement levels highlight areas where a pullback can reverse and head back in the trending direction, making them helpful in confirming trend-trading entry points.

Origins of Fibonacci Levels

Fibonacci levels are derived from a number series that Italian mathematician Leonardo of Pisa—also known as Fibonacci—introduced to the west during the 13th century. The sequence starts like this:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89.

Each new number is the sum of the two numbers before it. As the sequence progresses, each number is approximately 61.8% of the next number, approximately 38.2% of the following number, and approximately 23.6% of the number after that. Subtract 23.6 from 100, and the result is 76.4.

These are Fibonacci retracement levels: 76.4, 61.8, 38.2, and 23.6.

The Relevance of the Sequence

What Fibonacci and scholars before him discovered is that this sequence is prevalent in nature in spiral shapes such as seashells, flowers, and even constellations. As a spiral grows outward, it does so at roughly the same rate as the percentages derived from the Fibonacci ratios.

Some believe these ratios extend beyond just shapes in nature and actually predict human behavior. The thinking is that people start to become uncomfortable with trends that cause changes to happen too rapidly and adjust their behavior to slow or reverse the trend.

According to this theory, if someone started out with $100 in his wallet, he would begin to slow his spending—or stop altogether—once he has spent about $61.80 and has only about $38.20 remaining.

How to Use Fibonacci Retracement Levels

When a stock is trending very strongly in one direction, the belief is that the pullback will amount to one of the percentages included within the Fibonacci retracement levels: 23.6, 38.2, 61.8, or 76.4. Some models also include 50%.

For example, if a stock jumps from $10 to $11, the pullback should be expected to be approximately 23 cents, 38 cents, 50 cents, 62 cents, or 76 cents. Early or late in trends, when a price is still gaining or losing steam, it is more typical to see retracements of a higher percentage.

In this image, you’ll notice that between 61.8% and 38.2% there are two downward trends. This is an example of a Fibonacci retracement. The theory states that is a usual circumstance for stocks to trend in this manner because it is inherent in behavior to follow the sequence.

If your day trading strategy provides a short-sell signal in that price region, the Fibonacci level helps confirm the signal. The Fibonacci levels also point out price areas where you should be on high alert for trading opportunities.

Using a Fibonacci retracement tool is subjective. There are multiple price swings during a trading day, so not everyone will be connecting the same two points. The two points you connect may not be the two points others connect.

To compensate for this, draw retracement levels on all significant price waves, noting where there is a cluster of Fibonacci levels. This may indicate a price area of high importance.

Retracement Warnings

While useful, Fibonacci levels will not always pinpoint exact market turning points. They provide an estimated entry area but not an exact entry point. There is no guarantee the price will stop and reverse at a particular Fibonacci level, or at any of them.

If the price retraces 100% of the last price wave, the trend may be in question. If you use the Fibonacci retracement tool on very small price moves, it may not provide much insight. The levels will be so close together that almost every price level appears important.

Fibonacci retracements provide some areas of interest to watch on pullbacks. They can act as confirmation if you get a trade signal in the area of a Fibonacci level. Play around with Fibonacci retracement levels and apply them to your charts, and incorporate them if you find they help your trading.